What If Monetary Policy Doesn’t Work?

Maybe the “sell in May” telegram finally arrived after an unaccountable delay.

Maybe relentless rises on the back of ever thinner volumes brought oxygen-starved markets to levels where they just plain need to descend a little way for a breather.

Maybe central bankers are starting to feel nervous about the eventual unintended consequences of pumping yet more monetary stimulus into the economy.

Maybe, God forbid, people are starting to wonder whether central banks really can do much to deliver growth by lowering interest rates in a world where people are so stuffed with debt they don’t really want to borrow any more.

Or, more likely, equity markets worldwide could well be stumbling as a result of all four–and probably more–reasons.

There’s plenty of literature on seasonal effects in equity markets and “sell in May” is one of the few that actually works (see this paper by Jacobsen and Bouman).

Investors following the simple strategy of selling just before the summer and then buying back into the market at the start of November tend to outperform by a statistically significant amount in most major markets.

Markets also tend to “correct” after strong rises as investors lock in profits or rebalance their portfolios for any number of other reasons.

But these markets have been unduly driven by central bank activity and so it’s reasonable to assume that any substantial declines might have something to do with central banks too.

The end of the first and second rounds of quantitative easing in the U.S. triggered big down moves in global equities–since the financial crisis the correlations between the U.S. and other markets have become even stronger than usual.

One theory was that the Federal Reserve’s bond buying kept yields on “risk-free” assets below where they would otherwise be, thus driving down yields on risky assets like equities as well. Remove QE and Treasury bond yields go up and so must equity yields (and thus prices must fall).<

Except life didn’t actually work out that way. QE drove up yields as investors anticipated stronger economic growth in the future and this optimism, in turn, helped to boost equities. The prospect of the end of QE saw yields and equities fall back.

This theory falls down slightly with the Operation Twist and QE3 that followed–yields broadly speaking fell since then.

And, indeed, it could be that investors are looking over the various rounds of easing in light of subdued economic growth, low and falling inflation and might well be arriving at the uncomfortable conclusion that, notwithstanding what the Fed tells us, monetary policy just isn’t very effective.

In essence, this could well be a slow dawning that we’re not so different from Japan in the decade following its financial crisis of 1990. Which suggests that yields will remain low and economies will struggle and, yes, that equities need much further to fall.